Chapter 11
FINANCIAL ANALYSIS : Working capital and capital expenditures


A company’s working capital is the balance of the accounts directly related to its operating cycle (essentially customer receivables, accounts payable and inventories). Calculated at the year-end closing date, it is not necessarily representative of the company’s permanent requirement. Therefore, you must look at how it has evolved over time.

All of the components of working capital at a given point in time disappear shortly thereafter. Inventories are consumed, suppliers are paid and receivables are collected. But even if these components are consumed, paid and collected, they are replaced by others. Working capital is therefore both liquid and permanent.

Working capital turnover ratios measure the average proportion of funds tied up in the oper- ating cycle. The principal ratios are:

  • days’ sales outstanding: accounts receivable / sales (incl. VAT) × 365;

  • days’ payables outstanding: accounts payable / purchases (incl. VAT) × 365;

  • days’ inventory outstanding: inventories and work in progress / sales × 365;

  • working capital turnover: working capital / sales × 365.

When a company grows, its working capital has a tendency to grow because inventories and accounts receivable (via payment terms) increase faster than sales. Paradoxically, working capital generally continues to grow during periods of recession because restrictive measures do not immediately deliver their desired effect. It is only at the end of the recession that working capital subsides and cash flow problems ease.

A low or negative working capital is a boon to a company looking to expand.

he level of working capital is an indication of the strength of the company’s strategic position, because it reflects the balance of power between the company and its customers and suppliers.

We evaluate a company’s investment policy by looking at the following three criteria:

  • the extent to which production facilities are worn out, as measured by the net fixed assets/gross fixed assets ratio;

  • the purpose of capital expenditure – build up fixed assets, maintain them or let them run down – is determined by whether capital expenditure is greater than, equal to or less than depreciation;

  • analysis of the cash flow generated by investments. Any investment policy should, sooner or later, translate into increasing cash flows from operations. If not, the company will face financial difficulties.